After a couple split, they typically must also split up their retirement assets. Using a qualified domestic relations order can be critical to getting that split right and avoiding future problems and headaches.
What's surprising for many is that using a QDRO to divide qualified retirement plan assets doesn't always create the clean split that they expect — and that a former spouse can continue to affect a client's rights and obligations with respect to required minimum distributions for years to come.
Understanding the rules governing retirement accounts under a QDRO post-divorce can be critical to avoiding steep penalties for missed RMDs. Internal Revenue Service rules aren't what many clients will expect, and QDROs are complicated legal documents themselves, so it's important to dig into the details and options whenever a client decides to divorce.
QDROs and RMD Rules
ERISA-governed retirement plans typically will not allow a plan participant's former spouse to obtain the participant's retirement funds. That's true even if the divorce settlement grants a portion of the participant's retirement assets to the ex-spouse.
If the participant withdraws the funds to satisfy divorce settlement obligations, the tax consequences can be significant. Without a QDRO, the withdrawal can trigger the 10% early withdrawal penalty and will be fully taxable.
These tax consequences can be avoided with a QDRO that satisfies federal ERISA requirements. The former spouse's portion of the retirement account is transferred into a separate account within the plan, in the ex-spouse's name.
Complications can arise when it comes to calculating RMDs. Distribution obligations are typically triggered once participants reach their required beginning date (currently, age 73 and 75 for taxpayers born after 1959). Under IRS regulations, the participant's age continues to govern RMD obligations for the ex-spouse's separate account.
The former spouse, then, must begin taking RMDs at the same time as the original plan participant, regardless of their age and regardless of how long they've been divorced. The ex-spouse will use their own life expectancy to calculate the annual RMDs.
Missing an RMD can carry significant penalties. The Secure 2.0 Act reduced that penalty to 25% of the missed RMD, and the penalty may be further reduced to 10% of the missed RMD if the taxpayer takes all of their missed RMDs and files a tax return paying the required tax and penalty amount before the earlier of (1) receiving a notice of assessment of the RMD penalty tax or (2) two years from the year of the missed RMD.
IRA Rollover Option
A former spouse who is younger may wish to delay RMDs. That's especially true if the ex-spouse is in a relatively high tax bracket. It's often beneficial to delay RMDs until retirement, when an individual may have dropped into a lower tax bracket.
To avoid taking RMDs based on a former spouse's age, an individual can roll the funds from a QDRO separate account into a traditional IRA, which is not governed by ERISA, in their own name. Once the funds are in the account, RMD obligations depend on the individual account owner's age alone. Of note, any ERISA-mandated RMDs for the year of the rollover must be taken before the rollover can occur.
Once the funds are rolled over, they become subject to all generally applicable IRA distribution rules. The early distribution penalty may be a factor if the individual is younger than 59.5 and needs access to the funds. While the funds in the QDRO-created separate account would not be subject to an early distribution penalty even if the ex-spouse was younger than 59.5, they do become subject to possible penalties once they hit the IRA.
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